Zero-based budgeting methods

“The Barque of Dante” Eugène Delacroix (c. 1822)

Consider the following two equations:

Seriously; do it now before reading further.  One equation represents the essence of traditional static budgeting, and the other represents that of flexible zero-based budgeting.  Now click on and consider the Wikipedia article: zero-based budgeting

If you have read this far, I will assume you are a business executive, or a finance or accounting professional involved in organizational budgetary processes.  Now, if I told you the problems associated with traditional budgeting, and how zero-based budgeting can solve these problems, can be fully understood by understanding the two equations, would you be interested?  Anyone involved in budgeting, managerial finance and accounting really should be.  At an abstract level here’s why:

” … we have such tools as the equation or formula which enable [us] to learn in a few hours fundamental and pervasive features of the behavior of things which [we] could otherwise learn only imperfectly with great labor or not at all.”  Edward Lee Thorndike

At a less abstract level, understanding the precise, fundamental differences between traditional and zero-based budgeting is important for the intended reader because–as a number of Brazilian executives have told me–many Brazilian companies want to emulate the widely discussed zero-based budgeting success of Ambev, one of the world’s largest beverage companies based in Brazil.  And, strangely enough, even though zero-based budgeting has existed since the 1970s, it is not yet widely understood or used … 40 years later; not only in Brazil but, in my experience, in the USA as well.  So, I think it’s reasonable to conclude that people have not been taking Professor Thorndike’s advice … for a long time.

Because the intended reader is an experienced, technically-proficient professional, I will follow Professor Thorndike’s advice and proceed in a very concise, technical way focusing on explaining the basic formulas representing traditional budgeting and zero-based budgeting.

1. Budgeting methods and traditional performance evaluation

Budgeting defined.  In its most basic form, budgeting involves developing planned levels of revenues, variable costs and fixed costs for a future period …

… against which managerial performance is evaluated:

The subscripts here represent month, quarter, or year.

Traditional method of evaluating managerial performance.  Management performance evaluation using traditional budgeting methods is most often based on what is termed a static budget where …

The term “static” comes from the idea that regardless of differences between actual and budgeted product unit sales volume, price inflation, etc., the budgeted revenues, costs, and profit remain static; i.e., unchanged.  This can and most often does create a number of organizational pathologies.   Let’s see why … .

2. Static budgets cause performance evaluation problems

Performance evaluation problems caused by traditional budgeting methods mainly result from managerial performance evaluation using a static budget, which uses a single performance goal that does not take into account factors beyond the control of managers.  Consider a graph of profit (the black line) as a non-linear function of product unit sales volume:

Notice that budgeted profit is a single number, which depends on a single number: budgeted unit sales volume.  Budgeted profit is a static budget because even though actual profit very reasonably differs depending on product unit sales volume, the budgeted profit against which actual profit will be evaluated remains unchanged even as the expected unit sales volume changes as the performance evaluation period progresses.

If such product unit sales volume is beyond the control of the manager responsible for developing and achieving the budgeted profit–or, indeed, if any uncertain factor influencing profit is beyond the manager’s control–then performance evaluation using the static profit budget value results in incorrect inferences as shown in the graph.

3. Flexible budgets result in improved performance evaluation

The appropriate method of assessing managerial performance when there are factors beyond managerial control is based on a flexible budget, where budgeted profit is not a static value but is rather a function of factors outside managerial control:

So, the fundamental difference between traditional static budgets and flexible budgets is that static budgets represent single budgeted values, whereas flexible budgets represent functions of uncertain factors.

This means that correct inferences regarding managerial performance require an estimation of how performance objectives depend on factors under the manager’s control, and factors that are not under the manager’s control.

4.  Static budgeting results in managerial incentive problems

When managerial performance is evaluated based on static budgets, managers have the incentive to manipulate budgets to their expected benefit and can generally do so without the manipulation being observed:

Consequently, static budgets tend to be particularly ineffective in assessing managerial performance:

Under traditional performance evaluation methods based on static budgets, managers have an incentive for bias budgets to positively influence their performance evaluation.

5.  Example: Biased static budgeting and performance evaluation

Perhaps the simplest example of biasing static budgets towards positive management performance evaluation can be seen in the case of fixed costs:

Manager’s decision problem

A manager responsible for developing a static budget knows that based on detailed observation and analysis of administrative staffing needs for next year, R$ 800 million will be needed to pay salaries of administrative staff.  But because the manager knows that his performance will be evaluated against the static budget, the manager must choose the amount of bias and incorporate it into the budgeted amount:

Manager’s budgeting decision

The manager wants to maximize the likelihood of a positive performance evaluation based on the static budget, but must obtain approval for the budgeted amount.  The manager notes that real fixed wages in the previous year totaled R$ 1 million and that several government agencies and research institutions are projecting 10 percent inflation next year. Considering that this information is objective and observable, and that executive directors have approved salary budgets on the basis of prior year salary levels plus an inflation adjustment, the manager submits the following budgeted amount (and is approved):

It is hopefully clearly apparent that under this set of circumstances, the manager has substantial ability to bias the budget and to manage actual salaries in a way that substantially biases performance evaluation.

6. Static budgeting versus flexible (zero-based) budgeting

Although the title of this article is “Zero-based budgeting methods”, I actually have not explained it yet even once.  The primary reason for this is that the concepts of static budgeting and flexible budgeting are far more fundamental and, accordingly, understanding these concepts makes zero-based budgeting almost trivial.  To see this, consider the mathematical expressions for a traditional static budget for a fixed cost, and a flexible zero-based budget for the same fixed cost:

In the zero-based budgeting formula on the right-hand side, x = (x1, … , xk) represents the various factors that actually cause the costs.  As can be seen in this formula, zero-based budgeting in essence refers to only one thing:

Under zero-based budgeting, budgeted values have no fixed component independent of the factors that cause the actual values.

This means that, more generally, flexible budgeting and zero-based budgeting are essentially equivalent and that flexible / zero-based budgeting is generally applicable to all components of a profit function:

The above profit function–with component functions for unit selling price, unit sales volume, unit variable cost, and fixed costs all as a function of their respective causal factors–is the most general representation of flexible budgeting.  And with the additional condition that “fixed costs” (i.e., costs that are independent of unit production or sales volume) have no fixed component that is linearly independent of causal factors, then this is also the most general representation of zero-based budgeting as well.

As we’ve basically seen so far, an effective zero-based budgeting method provides managers with the incentives and assistance to develop flexible, unbiased zero-based budgeted values for use in planning and performance evaluation.  But governance and information systems must be properly designed …

7. Zero-based budgeting, governance, and information systems

Because zero-based budgeting is an integral component of a management planning and control system, experience suggests it is likely to be ineffective unless accompanied by effective corporate governance and information systems, which can be conceptualized as …

And because zero-based budgeting is an integral component of corporate governance and management control systems, it requires properly (re-)designed information systems, managerial assignments and performance evaluation.

Experience shows that effective corporate governance requires careful alignment between organizational objectives and management assignments, incentives and evaluation:

So, because flexible zero-based budgeting changes the way managerial performance is evaluated, it changes managerial incentives and other aspects of the corporate governance system.  It follows that governance systems, information systems, and zero-based budgeting systems must all be aligned to be effective.

8.  Implementing effective zero-based budgeting systems

I will now summarize things by providing a simple, concise outline of how to implement effective zero-based budgeting systems, including the (re-)design of governance and information systems:

Phase 1Evaluate corporate governance systems

Evaluate the alignment between business objectives, tasks and incentives of managers, and the method of evaluating managers’ performance; particularly for managers with budgeting responsibilities.

Phase 2Evaluate information systems

Evaluate the extent to which managers have the information needed to develop accurate, unbiased budgets; and, evaluate budgeting procedures including interviews of managers to elicit explanations about deviations between actual and budgeted performance.

Phase 3Develop flexible zero-based budgeting models

Zero-based budgeting (ZBB) requires development of models based on the estimated effects of causal factors on budgetary components.  This is accomplished by …

  • interviewing managers to identify actual causes of revenues and costs,
  • obtain causal factor data and estimate effects using econometric methods,
  • develop ZBB models based on econometric results, and
  • review the flexible ZBB models with managers responsible for budgeting.

Phase 4Redesign information systems

Redesign information systems to capture, measure, and report factors that cause performance results relative to the budgetary objectives.

Phase 5Redesign corporate governance systems

Redesign corporate governance systems to properly align business objectives, tasks and incentives of managers, and evaluation of management performance under the flexible ZBB system.

Q.E.D.

And there we have it!  Please let me know your thoughts in the comments below!

MMc
São Paulo

Caveats.  Please note: (i) views presented above are my own and do not reflect those of others; (ii) like anyone, I’m not infallible and am responsible for any errors; (iii) I greatly appreciate being informed of any significant errors in facts, logic, or inferences and am happy to give credit to anyone doing so; (iv) the above article is subject to revision and correction; and, (v) the article cannot be construed as investment or financial advice and is intended merely for educational purposes.  MMc